Two Sides to Every Coin

 

Why is there such a large disconnect between stock market performance and the real economy?

 

As we watch the global economy unravelling from the safety of our homes, many are confused as regards the astonishing performance of equity markets since the lows of March 23rd. The thing is, markets are unpredictable in the best of times, so it should also come as no surprise that things are even more difficult to work out, when we really have no clue as to what is going on. Far be it for us to provide answers when no one else can, but at the very least we can shed some light on why there is such a large disconnect between financial markets and the reality on the ground.


Foremost, it is worth noting that markets have always been dissociated with what’s going on in the real world and that’s because they are forward looking. A share price is the expectation of all future cash flows, discounted to a present value. That seems a bit abstract and may explain why learning things from a textbook is so difficult. Think of it this way: what would you pay for a company that has closed for business and is no longer producing any revenues? Not much, other than for the assets at hand, like the building, equipment and maybe a bit for the brand if there is any transferrable value. What about for a company that has no assets, but has developed a vaccine for the coronavirus? Name your price, and it is easy to see why this game of valuing shares is so difficult.


If you look at the work of people who do company valuations for a living, as in those highly esteemed and hugely paid “equity analysts”, you will always find a huge dispersion of share price targets. Taking our favourite example, Vodafone, the current price is 110p and the price targets from more than 26 analysts range from 75p to 220p. That does seem rather strange. After all, everyone is looking at the same numbers, meets with the same company managers, and uses the same models to perform the valuations. So, if we can’t get it right for a single stock, multiply the margin of error by a 100 when looking at the FTSE, and multiply the uncertainty by a 1000, because there is this little virus going around that could change our world forever.


Now that we have cleared that up, what are we to make of this rally and won’t the fundamentals catch up with these lofty expectations, if things truly are as bad as they seem? Yes, in the long run things are efficient and pigs don’t fly, but that doesn’t help us make money in the short term. Neither does it make it any easier to manage our risk. Should we take up our equity exposure or sell all we can, for there will be a second reckoning of epic proportions?


As always, the answer lies somewhere in the middle. We should always have some exposure to equites, because for one we don’t know, and it would be a shame to miss out on future gains. For another, the world will go on ticking. If you look at any long-term chart of equity markets, the second world war, the bursting of the internet bubble and even the crash of 2008 are mere blips in the astonishing success story that is the ownership of corporations. On the other hand, you would have to be a very brave soul indeed to bet it all on black when we are facing the greatest economic contraction since the great depression.

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